Question

Describe the shapes of AS curve. Discuss why the shape of AS curve varies depending on three time horizons. Using the aggregate demand-aggregate supply (immediate short-run) model and explain how an increase in business taxes would affect the price level and the real GDP. ( 3 points )

Answer 1

In immediate short-run, prices are completely rigid and so, a price level remains fixed. So the AS curve is horizontal at this price level..

In short-run, prices are partially rigid and partially flexible and so, an increase (decrease) in price increases (decreases) aggregate quantity supplied. So the AS curve is upward rising.

In long, prices are completely flexible and so, an increase (decrease) in price doesn't change aggregate quantity supplied. So the AS curve is vertical at potential output (GDP) level.

Increase in business taxes decreases business investment, so aggregate demand decreases. Since AS is horizontal at immediate short-run, lower AD only decreases real GDP, leaving price level unchanged.

In following graph, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply, which is horizontal) curves intersect with initial price level P0 and initial real GDP Y0. Lower aggregate demand shifts AD0 leftward to AD1, intersecting SRAS0 at point B with lower lower real GDP Y0.